Small is good? Small cap investing Aswath Damodaran

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Transcript of Small is good? Small cap investing Aswath Damodaran

  • Slide 1
  • Small is good? Small cap investing Aswath Damodaran
  • Slide 2
  • Small Cap Investing: Is it growth investing? In small cap investing, you invest in companies with low market capitalization. While some small cap investing is directed towards value stocks, the underlying basis for investing in small companies is often the belief that you have a much greater likelihood of getting growth at these companies, at a reasonable price. There is substantial empirical evidence backing this strategy, though it is debatable whether the additional returns earned by this strategy are really excess returns.
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  • Small companies have been winners over long time periods
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  • And it shows up globally
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  • Though the small Firm Effect has varied over time
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  • And there have been cycles in Small Firm Premium
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  • Is there a small cap premium? The small stock has become much more volatile since 1981. Whether this is a long term shift in the small stock premium or just a temporary dip is still being debated. Jeremy Siegel notes in his book on the long term performance of stocks that the small stock premium can be almost entirely attributed to the performance of small stocks in the 1970s. Since this was a decade with high inflation, could the small stock premium have something to do with inflation?
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  • And even if there is one, is it all in January?
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  • Possible Explanations It costs more to trade small cap stocks: The transactions costs of investing in small stocks is significantly higher than the transactions cots of investing in larger stocks, and the premiums are estimated prior to these costs. While this is generally true, the differential transactions costs are unlikely to explain the magnitude of the premium across time, and are likely to become even less critical for longer investment horizons. Difficult to replicate: Funds that invest in small cap stocks are often unable to deliver the premiums that you see in the paper portfolios that back the small cap effect.
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  • Difficulties in Replicating Small Firm Effect
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  • Risk Models and the Size Effect The capital asset pricing model may not be the right model for risk, and betas under estimate the true risk of small stocks. Thus, the small firm premium is really a measure of the failure of beta to capture risk. The additional risk associated with small stocks may come from Estimating risk: The estimation risk associated with estimates of beta for small firms is much greater than the estimation risk associated with beta estimates for larger firms. The small firm premium may be a reward for this additional estimation risk. Information risk: There may be additional risk in investing in small stocks because far less information is available on these stocks. In fact, studies indicate that stocks that are neglected by analysts and institutional investors earn an excess return that parallels the small firm premium.
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  • There is less analyst coverage of small firms
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  • But the risk in individual small stocks may not show up in a portoflio While it is undeniable that the stock returns for individual small cap stocks are much more volatile than large market cap stocks, a portfolio of small cap stocks has a distribution that is similar to the distribution for a large cap portfolio.
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  • Determinants of Success at Small Cap Investing The importance of discipline and diversification become even greater, if you are a small cap investor. Since small cap stocks tend to be concentrated in a few sectors, you will need a much larger portfolio to be diversified with small cap stocks. In addition, diversification should also reduce the impact of estimation risk and some information risk. When investing in small cap stocks, the responsibility for due diligence will often fall on your shoulders as an investor, since there are often no analysts following the company. You may have to go beyond the financial statements and scour other sources (local newspapers, the firms customers and competitors) to find relevant information about the company. Have a long time horizon.
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  • The importance of a long time horizon..